Although one could say that investors have simply been diversifying away from stocks into less volatile investments, I think much of this movement is simply performance-chasing: using the rear view mirror to guide future investing. Over the past decade Federal Reserve intervention combined with a weak economy, has caused interest rates to fall sharply, with the simultaneous rising of in the price of bonds, and bond funds. In fact, many long-term bond mutual funds and exchange-traded funds have risen by more than 50% over the past five years. At the same time, most stock market investors have seen modest returns and high volatility.
But that's the past. The question is what an investor today gains by cashing out of stocks and going into bonds. Although stocks are volatile, by most conventional measures they don't appear to be excessively valued. They are certainly less expensive than in 1999 and 2007 when investors were shunning bonds in favor of stocks. Today, stock dividends alone often exceed bond yields. Today the average dividend yield on U.S. stocks is over 2%, with many foreign market dividend yields exceeding 3% or 4%. For long-term investors (those with time horizons of a decade or more), holding quality stocks in a global, diversified way seems a prudent part of an investment portfolio.
For bond investors, it's a different story. Over the past three decades bonds have probably had the greatest bull run in American history. During that span bond rates have tumbled from over 15% to 2% or 3% or less. Recently bond investors were receiving just 2.8% a year for 30-year Treasury bonds and just 0.3% for 2-year Treasury bonds. After inflation these investors are getting nothing or less than nothing. Even the riskiest of bonds, high-yield or "junk" bonds, are now providing investors with low yields, with the potential for large losses.
Today's investors who are focusing on bonds' "high returns" can only be looking at past returns, not those likely in the future. Since interest rates cannot fall much further, the best case scenario for these investors is if interest rates stay at these rock-bottom rates for many, many years. Even in that case, those investors will receive a minimal income stream. The worst case scenario, and a probable one, is that interest rates will turn upwards at some point, perhaps spiking erratically in response to some financial or economic turmoil. Or investors could respond to the debt burden of the U.S. government and doubt the confidence that policymakers will be able to continue controlling interest rates. One of these scenarios could send bond yields soaring and the value of bond funds plummeting.
Just as with many stock investors in 1999 and 2007, many bond investors in the U.S. have never experienced a bear market in bonds. Such a downturn may be particularly distasteful for those investors, especially if they turned to bonds expecting continued strong, low volatility returns. And while the bursting of the bond bubble need not necessarily cause great pain for investors that are diversified and willing to ride out the decline, the downturn will likely cause many bond investors to abandon their "strategy" of investing in the most recent "hot" asset class.
Bond investments are a sensible, suitable investment for the majority of American investors. That's particularly so, if they can be purchased in a diversified way, such as via mutual funds or exchange-traded funds, and if they can be done so inexpensively. But the proportion that they make up of a portfolio should be based on things like an investor's age, investment time-horizon, and overall asset allocation plan. Bonds should not be used as an area to "temporarily" hide from stocks when stocks are volatile (stocks are always volatile), and investors should not be piling into bonds just because bonds have recently been the best performing asset class. These investors are no different than those piling into stocks at their peaks in 1987, 1999 and 2007. Most of those stock investors learned their lesson about performance-chasing, and the importance of a diversified investment portfolio. Bond investors should remember that lesson now, before this bond bubble bursts.
As with those owning stocks amid market downturns, staying the course will help bond investors ride out the decline in their bond investments. Bond investors need to remember that bonds are not riskless, particularly during times such as now, when bond yields are so low, and prices are high. Reversion to the mean is a very strong predictor of future market returns. On that score, bond investments could easily fall 30%, 40% or more. Individuals who hold bonds need to understand how risky their particular bond investments are, how potential declines would impact their overall investment portfolio, and whether they will be able to weather stormier times in the bond world.